Risk versus Return

The bail-out of customers of Northern Rock, Bradford & Bingley and now Icesave , has brought complaints from those who lost out in the so-called ‘pension scandal’ and from Equitable Life policy holders.

With hindsight, we can point the blame at excessive greed of bankers or poor regulation by the FSA and poor ability to control the lending policies of banks and their capital basis/borrowings.

But there is a more fundamental issue relating to risk and return and it is this. In our free market economy (which in some areas is too heavily regulated, but in other areas correctly regulated but with the wrong emphasis) investors are free to choose where to put their money. The options are numerous and whilst the old maxim that ‘If the return looks too good to be true, then it is.’ holds good for outlandish returns, those who have invested with, say, Icesave, might say that they were only improving their return by a half-one per-cent from that that they could have achieved with more regular UK investment houses.

However, it is still the case that if we are going to bail out all depositors, then there is actually no need for a market full of banks and building societies and other deposit institutions. We might just as well tell everyone to invest in National Savings and government stocks with the expectation of a 100% guarantee (unless the country is bankrupt!).

Does this mean that I am promulgating the argument that the government is wrong to try to bring stability to the market by offering this guarantee at the present time? – no, of course not. But it does raise a number of questions. Those who deposit monies with banks –which are profit-making , privately – owned entities – should understand that these were never risk-free. On this point there is an excellent article by Seth Freedman at The Guardian Online.

Secondly is there is any point in a depositors’ protection scheme if the government is going to make arbitrary decisions about to whom and when to extend the scheme beyond its stated coverage, i.e. the first £35,000 (now £50,000) of deposits with UK deposit-taking institutions.

One of the key lessons from this whole saga is the need to examine again , fundamental questions of risk v return , investor protection , the role of the FSA (if it still has one) in particular and of financial markets regulation in general.